US Tax Laws Change — Again

US Tax Laws Change — Again

December 01, 1999

Congress voted a number of tax law changes in late November that will affect the project finance community. Many of the same changes passed Congress in August, but were vetoed by President Clinton. Clinton is expected to sign the new measure.

Section 45 Credits

Congress extended a tax credit of 1.7 cents a kWh for generating electricity from wind and “closed-loop biomass” and added poultry waste to the list of eligible fuels. “Closed-loop biomass” consists of crops grown specifically to be used as fuel in a power plant. Lobbyists had hoped to persuade Congress to broaden the fuels list also to include wood and agricultural waste and landfill gas, but they were unsuccessful.

Existing law requires projects using eligible fuels be placed in service by June 30, 1999 to qualify for credits. Congress extended this deadline for another two years through December 2001.

The credits run for 10 years after a project is put into service.

Under current law, only the owner of the facility qualifies for credits. Congress made an exception for power plants using poultry waste that are owned by a “governmental unit,” like a municipality. In that case, a lessee of the power plant or the operator could claim the credits.

The California utilities won a victory. Congress said tax credits cannot be claimed on electricity from new wind projects put into service after June 30 this year if the electricity is sold under a power sales agreement with a utility signed before 1987. The only exception is if the power contract is amended to limit the electricity that can be sold under the contract at above-market prices to no more than the average annual quantity of electricity supplied under the contract in the five years 1994 through 1998 or to the estimate the contract gave for annual electricity output. “Above market” means for more than the avoided cost of the electricity to the utility at time of delivery.

This is the first time the tax laws have been used to reform power contracts at independent power facilities. The utilities worry that there is the potential for a large number of new wind projects to be built under socalled “standard offer contracts” that they were forced by law to sign in the 1980’s. If all these projects are built, they will add to the utilities’ stranded costs.

Basis Shifts

A number of companies have found ways to exploit a loophole to create additional tax basis in assets inside partnerships. Congress closed the loophole for new partnerships, but left it open for another 19 months for existing partnerships.

“Basis” is the investment that a taxpayer has in an asset. He uses it to measure gain when the asset is sold.

In a basis-shift transaction, a partnership drops some of its assets with a high tax basis into a new subsidiary corporation and then distributes the shares in the subsidiary to one of the partners to liquidate his partnership interest. This causes four things to happen.

First, the new subsidiary corporation takes a “carryover basis” in the assets that the partnership drops into it. This means that it has the same high basis in the assets that the partnership had in them.

Second, the distribution of shares in the subsidiary to the liquidating partner does not trigger any tax. The partner takes a “substituted basis” in the shares, meaning he has the same tax basis in the shares that he had previously in his partnership interest. In a basis-shift transaction, the partner starts with a lower basis in his partnership interest than the partnership has in the shares it distributes. Thus, the partner is forced to shed basis.

Third, the partnership makes a socalled section 754 election. This allows it to increase the basis in its remaining assets by the tax basis that the liquidating partner had to shed.

Fourth, the partner then liquidates the corporation whose shares he was distributed. The liquidation is tax-free. After the liquidation, the partner ends up owning the assets that the partnership dropped into the subsidiary corporation directly. His tax basis in the assets is a “carryover basis,” meaning the basis that the partnership originally had in them.

The net effect is to increase the total basis in partnership assets. The transactions also produce other benefits.

Congress voted to require the subsidiary corporation to reduce its basis in its assets by the amount of the shed basis. This rule applies retroactively to distributions of corporate shares after last July 14. However, a transition rule allows another 19 months through June 30, 2001 for partnerships to do these transactions with persons who were their existing partners last July 14.

Installment Sales

Accrual taxpayers will no longer be able to use the “installment method” for reporting gain from the sale of assets. In the past, when an asset was sold for installment payments over time, the seller could report his gain ratably over the same period. Congress robbed this benefit of much of its value in 1988 by imposing an interest charge on anyone taking advantage of the provision. The new tax bill repeals use of the installment method altogether for accrual taxpayers. The change takes effect for sales occurring on or after the day President Clinton signs the measure. Most large companies are accrual taxpayers.

Fuel Contracts

Current law is unclear about whether a payment to cancel a fuel supply contract is a “capital loss.” Companies have a harder time deducting capital losses than ordinary losses. The bill makes clear that “supplies of a type regularly used or consumed by the taxpayer in the ordinary course of [his] trade or business” are not capital assets. This should have the effect of also clarifying that payments to cancel contracts to buy such supplies are not capital losses. The change applies to payments on or after President Clinton signs the bill.

Power Marketers

Congress clarified that trading in “commodities derivative financial instruments” produces ordinary income for power marketing companies — not capital gain. This should be helpful, since power marketers usually want to avoid mismatches in character between income and loss positions on contracts. (Most of their income is already ordinary income.) A “commodities derivative financial instrument” is a contract that is for, or an instrument that is tied to, a commodity like electricity and whose value is linked to an index. “Index” is defined broadly as “objectively determinable financial or economic information” that is not unique to the parties and not within their control.

The bill also clarifies that hedging transactions produce ordinary income and loss — not capital gain or loss — provided the hedge is “clearly identified as such before the close of the day on which it was . . . entered into.” Both provisions apply to any instrument “held, acquired, or entered into,” or “transaction entered into,” from when President Clinton signs the bill.

Research Credit

The bill extends the so-called R&D tax credit through June 30, 2004. The credit expired at the end of last June. The bill also increases the amount of the credit. Companies that qualify for the credit currently can compute it in one of two ways. Under one approach, the credit is 20% of the amount by which the company increased its research spending above a base. The other way is to compute it under a sliding formula that rewards companies for spending more than 1% of their gross receipts on research. Effective next year, the credit under this alternative approach would be 2.65% of research spending above 1% of gross receipts, 3.2% of such spending above 1.5% of gross receipts, and 3.75% of research spending above 2% of gross receipts.

Foreign Lending

US banks, insurers and finance companies that make loans to foreign borrowers have a hard time deferring US taxes on the interest they earn on these loans. US taxes cannot be deferred on passive income. The banks argue that this is active income for them. Congress wrote a temporary “active financing exception” into the law in 1997. The bill extends it through 2001.

 

By Keith Martin